Duplicate Loss on Disposition of Subsidiary

Before the Tax Reform Act of 1986 amended IRC section
336, it was possible for owners to remove assets from a corporation
without a corporate-level tax. Section 336 now requires taxpayers to
recognize a gain or loss on any assets they remove from a corporation
in a liquidation. As a result CPAs have been looking for methods to
help clients remove unwanted assets from corporations without
triggering a tax. The consolidated return regulations under IRC
section 1502 offered some effective methods—termed “mirror subsidiary
transactions.” The Treasury Department subsequently wrote regulations
section 1.1502-20 to curb these perceived abuses. It disallows most
losses by a consolidated group on the disposition of an affiliated
subsidiary.

In 1984 Rite Aid Corp. acquired 80% of Penn Encore in an asset sale;
it acquired the remaining stock in 1988. Rite Aid included Penn Encore
in its consolidated return filing. Penn Encore was marginally
profitable for several years, but then had large losses immediately
before Rite Aid disposed of the stock. In 1994 Rite Aid sold the
company to an unrelated party. The purchaser did not make an IRC
section 338(h)(10) election to treat the transaction as an asset sale.
Rite Aid reported a $22,136,739 loss on the sale.

Regulations section 1.1502-20 disallows “duplicated losses” on a
consolidated group’s disposition of an affiliated subsidiary. A
duplicated loss is the excess of a subsidiary’s adjusted basis in its
assets over the value of those assets immediately after a sale. Penn
Encore’s duplicated loss exceeded the loss Rite Aid reported, so the
IRS disallowed Rite Aid’s deduction. The company paid the taxes and
sued for a refund in the Court of Federal Claims. The court agreed
with the IRS and disallowed the loss. Rite Aid appealed to the Federal
Circuit Court of Appeals.

Result. For the taxpayer. The appeals court
held that Rite Aid could deduct a duplicated loss on its disposition
of an affiliated subsidiary. It based this finding on its opinion that
Treasury had overstepped its authority in disallowing duplicated
losses.

The opinion discusses the section 1502 regulations that delegate to
the secretary of the Treasury the responsibility for writing
regulations that insure consolidated returns clearly reflect a group’s
income tax liability and prevent the efforts to avoid such a
liability. The election to file a consolidated return requires
corporations to consent to all the relevant regulations. But another
case, American Standard (602 R.2d at 261), pointed out
section 1502 does not authorize the secretary to choose a method that
imposes a tax on income that otherwise would not be taxed.

The court agreed with the taxpayer that disallowing the duplicated
loss would distort rather than reflect the group’s tax liability and
the regulation’s requirement would “contravene Congress’ otherwise
uniform treatment of limiting deductions for a subsidiary’s losses.”
Consequently, the court determined the regulation is “manifestly
contrary to the statute.”

As a note of caution, a loss on the disposition of a subsidiary’s
stock is generally a capital loss that taxpayers can use to offset
only capital gains. According to Arkansas Best (83 TC 640)
and many other cases, ordinary loss treatment is available only if the
taxpayer holds the stock for one of the exceptions detailed in IRC
section 1221.

There had been a great deal of discussion and objection when the
Treasury Department proposed, amended and eventually finalized
regulations section 1.1502-20. This is the first court decision to
directly refute the controversial regulation. Consolidated groups that
accepted the disallowance of duplicated losses should consider
amending any open years’ tax returns and eventually appealing the IRS
disallowance to the Court of Federal Claims.

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